By Lynn Novelli

Storage REITs appear to have emerged intact following the storms of 2007, returning to the more normal pattern of steady and positive performance.

"Storage REITs underperformed the industry overall in 2007, as growth slowed in the wake of hurricane-related move-outs and tough comps in Florida," says Christine McElroy, head of Banc of America Securities' REIT equity research team. However, looking ahead for the second half of 2008, "sector fundamentals will stabilize at more normal growth rates, as conditions in Florida appear to have bottomed out and the national players become less aggressive on pricing and concessions."

Sector Stats
# of REITs	4
Industry Market Cap (in thousands)	$17,705,000
% of Industry	5.70%
Yield	2.99%
YTD Total Return	27.53%
One-Year Return	-8.01%
Three-Year Return	16.94%
Five-Year Return	24.43%
Average Daily Trading Volume (Shares)	918,357
Source: NAREIT data as of Apr. 1, 2008

Nonetheless, concerns about the relationship of sector fundamentals to the housing industry have lingered in the minds of some analysts well into 2008. McElroy says she believes the slide in home construction and sales negatively impacts the storage industry, pointing out that demand for rental storage units should decline in tandem with house buying and selling. "As housing transactions slow, demand for space slows," she says.

True enough, says Jeff Donnelly, a REIT analyst with Wachovia Securities, but other offsetting factors keep demand for storage fairly steady. "Even though the average size of the American home is now 2,400 square feet, people still don't have enough space," he says. "Consumer goods are relatively cheap right now, and Americans tend to acquire more things than they can store."

Stabilizing Influences

There's more to demand for storage than moving-related activities, agrees Michael Knott, an analyst with Green Street Advisors. "Customer demand drivers are diverse, such as the death of a relative, divorce, marriage, college and military service. Storage demand should not be in a free fall, and there are indications that it is not."

Moreover, 30 percent of self-storage nationwide is rented by corporate clients, primarily for file storage. In a changing economy, corporate tenancy may decline if small businesses fail and both large and small businesses implement cost-cutting measures. However, McElroy notes, "the impact could be muted, as self-storage is often a lower-priced alternative to other rental options, such as industrial condos for contractors and on-site storage for services-related small businesses."

Other analysts have noted that any downturn in corporate business during an economic slowdown can be tempered by an increase in rental demand from other sources. For example, families might downsize to smaller homes or apartments, and cash-strapped renters might "double up" with a roommate to save money. As a result, some contend that the net change in occupancy is likely to be negligible.

Occupancy in 2008 is hovering around 80 percent, in line with 2007. This falls short of the historic average of 84 percent to 86 percent that the sector enjoyed between 1999 and 2004, according to Prudential Real Estate Investments. However, the industry seems to be stable.

Overall, despite the persistently softer fundamentals that first surfaced in February 2007, "storage REITs are holding up fairly well," Donnelly says.

Marc Boorstein, a principal with MJ Investments in Chicago, specializes in self-storage transactions, and sees some encouraging signs in the sector's fundamentals. "REIT stock prices have stabilized, and occupancies and rents haven't fallen off a cliff, although lease-up of new units is slower," he says. "Overall, the sector is not feeling as much of an impact from the credit crisis as are other types of REITs."

Consistent Rental Growth

The storage sector is open to rapid shifts in rents with characteristically short-term leases, for better or worse. The downside is that income can decline rapidly when economic conditions are deteriorating and units are vacated and not re-leased. The advantage, which storage REITs should experience when real estate starts to recover from its current slump, is that storage rents can react quickly to improving fundamentals and owners can easily mark to market.

Historically, year-over-year rental growth is 3 percent to 5 percent for more than 80 percent of properties in storage REIT portfolios, according to Bank of America. This is consistent with anticipated year-over-year rental growth for 2008 of approximately 3 percent and revenue and NOI growth for the year of 2.5 percent to 4 percent. "Some occupancy upside and modest rental growth will drive internal growth in 2008," McElroy says.

Mimicking other, larger REIT sectors, such as apartments, office and retail, self-storage REITs are subject to market differences in rental growth. At the sector's core, "storage resembles retail in that population density and income levels are demand generators," Donnelly says. "Geographic areas with the highest population density correlate with storage REITs with the highest rental growth."

However, Boorstein notes, some markets that usually lead the pack in rent appreciation now are merely "holding their own." South Florida, dealt a severe blow by housing and credit market problems, is a prime example, he says.

Self-Storage Snapshot The self-storage industry grew from 289 million square feet in 1984 to 2.2 billion square feet at the close of 2007. The four public REITs—Extra Space Storage, Public Storage, Sovran Self Storage Inc. (NYSE: SSS) and U-Store-It-Trust (NYSE: YSI)—own a total of more than 3,000 properties. This is approximately 6 percent of all self-storage properties in the United States. The total market capitalization value of the entire U.S. self storage industry is in excess of $220 billion. Source: Self Storage Association

Restrained Supply

The heyday for development in the storage sector was the early 1990s, when storage REITs were still in their infancy and demand was outpacing supply. The pace has slowed considerably since then, and the sector will see no more than a 3 percent increase in new supply in 2008, Donnelly predicts. In the long-term, he suggests that growth may slow even more, "as credit market issues creep down to the smaller banks, moving slowly from Wall Street to Main Street."

Knott pegs sector supply growth even lower, approximately 1 percent annually in recent years. "It is tougher to build in desirable areas, although land prices are likely to come down as the real estate boom unwinds," he says.

McElroy says that overall development in the sector will be curtailed for the rest of 2008, as access to capital continues to be difficult. "We expect overall supply growth in the sector will remain low, a function of longer lease-up times, stricter zoning and narrower spreads between development yields and acquisition cap rates," she says. "That said, larger, well-capitalized self-storage owners continue to have access to capital for development."

While the current credit woes persist, however, large-scale development will be slow, Boorstein says. Public Storage (NYSE: PSA), for example, has only 29 projects planned through the end of 2008.

The New Urban Phenomenon

The markets of choice for those REITs with the capabilities for development will be the coastal markets, including Boston, New York and San Francisco, Donnelly suggests. In contrast to the usual view of self-storage as a suburban phenomenon, "urban areas are prime for new development," he says.

In major metropolitan areas where small apartments have large price tags, storage is at a premium. The occupants, whether upscale families or single professionals, tend to have a lot of possessions that they need to store, and downtown, multi-floor storage facilities may be the right solution.

The storage REITs already are testing the concept, Donnelly reports. Public Storage has built some four- and five-story facilities in urban areas, and Extra Space Storage (NYSE: EXR) opened a three-story property in Chicago in 2006, he reports.

Waiting It Out

In the current challenging economic environment and the risks inherent in ground-up development, some analysts believe the storage REITs will consider acquisition a more reasonable growth strategy than development this year. With REITs owning less than 10 percent of storage facilities nationwide and banks willing and ready to write loans to the REITs, opportunities usually abound.

However, Boorstein reports that in the first quarter, acquisitions were down by at least 75 percent from 2007. He attributes this drop to the loss of the CMBS market and "the Wall Street re-sellers" that historically have fueled acquisitions. When the CMBS market comes back, storage REITs will return to their previous level of acquisition activity, he predicts.

Meanwhile, he says, investor groups such as private equity and opportunity funds are waiting for the right time to partner with smaller self-storage owners to develop or acquire portfolios of Class A properties, in competition with the storage REITs. "There are a lot of properties available and a lot of equity waiting right now," Boorstein says. "The players are trying to decide what to do and when to do it."